Angel Investors - Do You Want Venture Capitalists in Your Deals?

By Growthink

Created 06/17/2009 - 00:34

The typical wisdom regarding the appropriate financing course for startup goes as follows:

Founders start the company in classic "bootstrap" fashion - with a combination of sweat equity and their own financial resources. This usually consists of their personal savings, credit cards, and small loans from relatives (Mom, Dad, Uncle Bob, etc.).

Through connections, or through a chance meeting at a networking or social event, an angel investor hears the entrepreneur's story, likes him or her and the technology, and on the spot, writes a check to provide the company with its first outside financing. The angel then introduces the entrepreneur to his or her wealthy friends and business connections who, based on the good reputation and respect that the angel has with them, also invest.

With this capital, usually totaling between $100,000 and $1 million, the company accomplishes a number of key technical milestones, gets a key beta customer or two, and then goes on a "road show" to venture capitalists around the country. The first institutional financing round - usually between $3 and $10 million - is the first of a number of rounds of outside investment over a period of 3 - 5 years. With this capital, the company propels itself to $50 million+ in revenues and to either a sale to a strategic acquirer or to an initial public offering.

With the exit, the entrepreneur and the original angel investor become fantastically rich (or in the case of the angel, even more so), and are lauded far and wide for their deep and keen predictive insight.

The cycle is then repeated - the original angel investor utilizing the windfall from their successful exit to fund more companies. And they are now joined in their investing by the once impoverished but now wealthy entrepreneur.

All live happily ever after.

It all sounds wonderful and it is. The only problem is that it mostly a fairy tale. Here is what really happens:

The entrepreneur pours their lives, their fortunes, and their sacred honor into their company- at great personal sacrifice to them, their families, and everyone connected to the enterprise.

A "black swan" investor appears mostly out of the blue to fund the deal - less concerned re the efficacy of the technology than by the talent, desire, and grit of the entrepreneur. Technical progress and market traction are much slower and cost a lot more than anticipated. There are a lot of dark, hard days.

There is considerable internal debate around whether or not to solicit and/or accept outside venture capital. For most companies, it is simply a non-starter. Management has the wrong pedigree, is geographically undesirable, competes in the wrong industry, and/or has a business model that lacks "scalability credibility" with the venture community.

Usually unbeknownst to all, the conversation and decisions around pursuing or accepting a venture capital round above will be the factor most highly correlated with their expected return on investment. But here is the key – contrary to popular wisdom it is negatively correlated.

New, groundbreaking research from the Ewing Merion Kauffman Foundation on Entrepreneurship shows that the #1 key for the angel investor returns in emerging technology deals is that there is never any venture capital invested in the company!

As interestingly, the data shows that when you remove a follow-on venture capital round from angel invested deals that expected returns skyrocket.

The data is somewhat inclusive as to why this is. I surmise three main reasons:

The Best Metric for the Health of A Company is Cash Flow. By definition, companies that receive venture capital cannot fund their businesses from operations - and thus need to seek outside capital. This may lead to inherent negative selection to venture deals – whereby the sample of companies that need outside capital are by definition weaker companies.

Venture capitalists Have Very Different Objectives than Angel Investors. Venture capital funds are usually 7 - 10 year partnership structures whereby the general partners, the VC’s, manage the capital of the limited partners, usually institutions (endowments, pension funds, etc.). And at the end of the period, all profits and proceeds are distributed to the various partners on a pre-determined split. These splits are normally such that the general partner professional money managers need to obtain a “highwater” return for their limited partners before they, as the general partners, see any return. beyond their management fees In practice, this creates a huge incentive for the general partners to hold on for home runs, and to be reasonably indifferent regarding smaller (less than 3x returns). As a result, the VC will often block a portfolio company from harvesting a very attractive, but not a home run, investment return. Or as counter-intuitively, press for a far more risky strategy than the entrepreneurs or the angel investors in the deal would prefer.

Venture capitalists Cut Tough Deals. Venture capitalists for the most part are very nice guys and passionate about entrepreneurship, but they are not shrinking violets. And they hire very aggressive securities attorneys to represent their interests. This combo all too often leads to various forms of deal unpleasantness - ncluding cram-down rounds, liquidation preferences, and change of control provisions, among others. Which in turn often leads to a lot of very unhappy founders and angel investors even in somewhat successful exits.

My suggestions for the angel investor looking to make money? First, look for "one and done" deals - companies that need just one round of outside capital to get them to positive cash flow. Second, look for companies that have short and realistic liquidity (exit, IPO) timelines. And third, don’t get star-struck by big VC interest in your deal. It can often be a double-edged and very sharp sword.